Recovery of Financial Markets and Institutions and Challenges in Post-Crisis Era

Table of contents

Executive Summary

Table of contents

List of figures

1. Introduction

2. Effects of the financial crisis on Stock markets

3. Recovery process and political actions
3.1 Monetary policies
3.2 Fiscal policies

4. Financial regulatory reforms

5. New trends and challenges in the financial environment

6. Conclusion

References

List of figures

Figure 1 Post-crisis growth scenarios for the US economy, Source: Subacchi (2010)

Figure 2 Pre-crisis and post-crisis growth trends for the US and euro area, Source: Subacchi (2010)

Figure 3 Effects and performance of the S&P 500, Source: Bloomberg (2011)

Figure 4 Effects and performance of the FTSE 100, Source: Bloomberg (2011)

Figure 5 Effects and performance of the German DAX, Source: Bloomberg (2011)

Figure 6 Taxonomy of policy spillovers, Source: Petri and Plummer (2009)

Figure 7 The ECB main refinancing rate and the FED funds target rate, Source: Bloomberg (2011)

Figure 8 Effectiveness of monetary policies, Source: IER (2011)

Figure 9 Influence of fiscal policies on S&P 500, Source: Bloomberg (2011)

Figure 10 Influence of fiscal policies on FTSE 100, Source: Bloomberg (2011)

Figure 11 Influence of fiscal policies on German DAX, Source: Bloomberg (2011)

Figure 12 Development in the bank capital requirement according to Basel 3, adjusted from Source: adjusted from German Ministry of Finance (2011)

Figure 13 Consumer Price Indexes of USA, United Kingdom and Germany, Source: Bloomberg (2011)

Executive Summary

This coursework examines the effects which the financial crisis from 2007 to 2009¹ had in financial markets and institutions. Particularly, we are deeply analyzing the impact in the Stock Markets² in the USA and Europe. We will concentrate on US stock market (S&P 500) and provide an incessant brief link to European stock markets such as FTSE 100 and DAX. The financial crisis from 2007 to 2009 is considered by many economists to be the worst crisis since the Great Depression of the 1930s. Furthermore, the use of monetary and fiscal policies and regulatory reforms is observed as well as what where the implications of these actions. Additionally, a discussion concerning the prospects of financial regulatory and the implications for the financial sector and economic growth are of great importance. To sum up, new trends and developments of the financial landscape and new challenges for partici- pants are discussed.

1. Introduction

The crumple of the U.S. housing bubble in 2006, caused the values of securities tied to U.S. real estate pricing to drop, as a result to harmful the financial institutions internationally. (Duca et al, 2010) Issues concerning bank solvency, declines in credit accessibility and damaged investor assurance had a collision on global stock markets, where securities experienced large losses during late 2008 and early 2009. Economies globally slowed during this period, as credit tightened and international trade declined (Prego, 2009a). Critics discussed that agencies and investors failed to price the risk involved with mortgage-related financial products, and that governments did not regulate their practices to address 21st-century financial markets. (Cukierman, 2011) Governments and central banks reacted with unprecedented fiscal stimulus and monetary policy expansion.

The so-called Subprime crisis began in the early months of 2006 when the housing market collapsed in the US (Acharya et al , 2009 ). In September 2008 it turned to a financial crisis and a deep recession after the Lehmann Brothers insolvency. The 2007-2009 recession was the most severe economic contraction since the 1930s. The slowdown of economic activity was reasonable through the first half of 2008, but at that point the weakening economy was overtaken by a major financial crisis that would make worse the economic weakness and ac- celerate the decline (Elwell, 2010). When the fall of economic activity finally bottomed out in the second half of 2009, real gross domestic product (GDP) had contracted by nearly 4.0%, or by about $500 billion³. The decline in economic activity was much sharper than in the two most recent recessions, in 1990 and 2001 respectively. Consequently, mortgages were given by lenders to borrowers who in any circumstance where not capable to carry the burden of the repayment schedule on the assumption that home prices would continue to ap- preciate indefinitely.

The recession was connected with a major financial crisis that made worse the negative ef- fects on the financial system. Declining stock and house prices led to a large decline in household economy, which dropped by over $10 trillion during 2008 and 2009. Addition- ally, the financial panic led to a detonation of risk premiums⁴ that froze the flow of credit to the economy.⁵ As a result during 2008 and 2009 the economy received some negative shocks. On the other hand, unlike in 1929, the severe negative desires did not turn a reces- sion into a depression, perhaps due to timely and sizable policy replies by the government aided to maintain aggregate spending and constant the financial system (Prego, 2009b).

The stock market activity is one of the most important activities in the commercial world which got influenced because of the financial crisis. The stock market indices are one of the principal signs of the economic activities.

As we can see, Figure 1 illustrates the post crisis growth scenarios from 2005 until 2020 for the US economy. From 2005 we can observe an increase of GDP. All scenarios expect a sustainable growth after the recovery of the financial crisis.

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Figure 1: Post-crisis growth scenarios for the US economy (Subacchi, 2010)

Similar to Figure 1, Figure 2 indicates the pre-crisis and post-crisis growth estimation of the US and the euro area. The crisis in 2007 - 2009 had a stronger impact to the US economy in comparison to the EU economy. The growth impact in Europe is more flat during this period. However, the growth after the crisis is expected to be stronger in the US.

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Figure 2: Pre-crisis and post-crisis growth trends for the US and the euro area (Sub- acchi, 2010)

A declining stock index echoes the dampening of the investment climate while an increasing stock index shows more assurance of the economy. The increasing investment on stocks raises stock prices and produces profits. In the next chapter we will see how these economic figures affected the stock markets.

2. Effects of financial crisis on stock markets

The US subprime crisis, as a result of low interest rates and “easy” cheap money in the mar- kets, started as regional problem which expanded globally through the securitization market affecting the global real economies and thus lead to a downturn in the stock markets. The subprime crisis became a crisis of confidence between banks and thus to a bank- and finan- cial crisis which led us to a global recession (Weber, 2009). Madura (2010:256) mentions that stock markets becoming more and more globalized by barriers between countries have been removed. Bartram and Bodnar (2009) are supporting this argument by providing evi- dence about the correlation between equity markets. Furthermore, it is to say that in many cases where crisis like 2007-2009 affects large countries with large economies tend to affect other countries because economies and stock markets are globally integrated. (Madura, 2010:288) Therefore it is to assume that the US stock exchange (NYSE) with the most in- fluential index S&P 500 in terms of market capitalization⁶, affected the stock markets glo- bally. Typically, a country’s stock market index should be seen as strong indicator of a country’s economy. For instance, if the GDP and other macroeconomic indicators are rising (see Figure 1 and 2), the financial markets, especially the stock markets, should perform well either and vice versa.

In relation to Figure 2, Figure 3 shows the effects of the financial crisis in the S&P 500 in- dex. From the highest point before the crisis in October 2007, the index declined 56.76% till March 2009, which was the lowest point. A slow downturn occurred at the end of 2007 and after the Lehman Brothers insolvency this trend sharpens significantly by declining approx- imately 25% in two weeks. This trend maintained till February 2009 where the recovery process of the S&P 500 began. From this period on, the index needed less than one year to reach the pre-Lehman Brothers level. From September 2010 till today, the index is rising again constantly. However, the S&P 500 index has not reached the high level from October 2007. Even though, the recovery performance from the lowest point in the crisis to the highest point in the recovery process is almost 98.51%.

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Figure 3: Effects and performance of the S&P 500 (Bloomberg, 2011)

In figures 4 and 5 we can see that the FTSE 100 and the German DAX performed very similar to the S&P 500. The FTSE 100 in figure 4 downturned 47.82%, whereas the recovery performance from the lowest point is 73.44%. The German DAX in figure 5 had a downturn of 54.60%, whereas the recovery performance is 73.44%.

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Figure 4: Effects and performance of the FTSE 100 (Bloomberg, 2011)

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Figure 5: Effects and performance of the German DAX (Bloomberg, 2011)

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¹ The literature is at issue with this point. On the one hand some writers mention that the financial crisis, which started in 2007 and became worst with the Lehmann Brothers insolvency in 2008, is still in progress. On the other hand experts state that the main indications for a deep financial crisis disap- peared, therefore we cannot talk anymore about a crisis. For our purpose in this coursework we will agree and follow the second opinion.

² The expressions Stock markets and Equity markets are often used as synonyms. For the use in this coursework we disclaim for such a distinction.

³ Real GDP is the output of goods and services produced in the United States.

⁴ Risk premium means compensation to investors for accepting extra risk over relatively risk-free invest- ments such as U.S. Treasury securities

⁵ Data on wealth and financial flows available at the Board of Governors of the Federal Reserve System. Source: http://www.federalreserve.gov/releases/z1/Current/

⁶ The market capitalization is equal to the total number of all shares in the index, multiplied by the sum of the current share prices.